Modeling Swap Hedges for Uncertain Construction Loan Draws

Summary

The document asks how to choose a second interest rate swap’s notional schedule when construction loan drawdowns are arriving faster than forecast and may accelerate further. The borrower already pays fixed and receives floating on a swap sized to the original draw schedule, while the underlying loan pays floating and the permitted hedge ratio is constrained. Total loan notional is capped, but the timing of draws is uncertain.

It frames the decision as an optimization problem over possible future loan notionals and timings, with the aim of managing the combined swap portfolio against the loan exposure. However, it offers no optimization objective, probability model, constraints beyond the stated hedge-ratio band and notional cap, calculation, or outcome. The question therefore identifies a practical hedging problem rather than presenting a solution; the optimal schedule would depend on the drawdown scenarios and the borrower’s chosen cost, risk, and hedge-effectiveness criteria.

Key ideas

• The borrower’s existing swap follows the original forecast of construction loan drawdowns.
• Faster and potentially further-accelerating draws create uncertainty about how much floating-rate exposure needs hedging over time.
• A second swap’s notional profile must be considered together with the existing swap and the loan.
• The document poses an optimization question but does not specify an objective function or propose a solution.

Tags

# How to optimally hedge construction loans with interest rate swaps?


# How to optimally hedge construction loans with interest rate swaps?












We are a borrower with a construction loan that is pay floating. At the inception of the loan, we entered into a pay-fixed/receive-floating interest rate swap with a growing notional profile that aligned to the original forecast of construction draws. The total cost of the contract is capped at 100MM (i.e. I know the total notional will never grow to more than 100MM). Our loan requires us to stay within 90% and 100% notional hedging.

The project (managed by a third party) is now accelerating, requiring faster drawdowns than originally contemplated. It may accelerate further.

As I think about how to enter into a second layer of swaps to deal with this adjusted drawdown profile, I've started to wonder what the "optimal" notional profile is for this second swap, given a distribution of possible notional amounts/timings.

What is my "optimization model" concerning the management of my interest rate swap "portfolio" in the context of uncertain notional amounts (i.e. the timing of the construction loan drawdowns)?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.